Roth IRA conversions: Still tax-smart

BillBischoff

In 2010, I wrote that the conditions were ideal for converting traditional IRAs into Roth accounts. Previous restrictions on conversions had been removed, and income triggered by conversions was taxed at relatively low rates. Today, we are once again looking at excellent conditions for Roth conversions. Here’s how to take advantage:

Conversion basics

A Roth conversion is treated as a taxable distribution from your traditional IRA, since you’re deemed to receive a taxable payout from your traditional account with the money then going into your new Roth account. So a conversion before year-end will trigger a bigger federal income tax bill for this year—and maybe a bigger state income tax bill too. However, two positive factors may outweigh the extra 2012 tax hit.

Today’s federal income tax rates might be the lowest you’ll see in your lifetime, especially if the so-called Bush tax cuts expire this year as scheduled. So if you convert this year, you’ll pay today’s relatively low rates on the extra income triggered by the conversion and completely avoid the potential for higher future rates on all the post-conversion income that will be earned in your new Roth account. That’s because qualified Roth withdrawals taken after age 59 1/2 are totally federal-income-tax-free.

If you convert this year, you don’t have to worry about the extra income from converting causing you to be hit with the new 3.8% Medicare surtax on investment income, which will kick in next year. While the extra income from a 2013 conversion would not itself count as investment income for purposes of the 3.8% surtax, it would raise next year’s modified adjusted gross income (MAGI). Higher 2013 MAGI could, in turn, cause some or all of next year’s investment income to be hit with the surtax, especially if you convert a traditional IRA with a big account balance. While not everyone who converts in 2013 will be exposed to the surtax, nobody who converts this year will be exposed, and that’s a good thing.

The combined tax-hiking impact of the Bush tax cuts going bye-bye and the looming 3.8% Medicare surtax has been dubbed Taxmageddon. The point to be made here is that a Roth conversion done this year can allow you to keep more of your post-2012 income out of Taxmageddon territory.

Don’t forget the impact of 2010 conversions

If you chose to spread the income from a 2010 Roth conversion 50/50 over 2011 and 2012 (as you were allowed to do), you already have some conversion income on the books for this year. So if you do another conversion this year, your 2012 income will be that much higher. Take that into account when estimating the extra tax bill from a 2012 conversion.

You can reverse an ill-advised conversion

Another nice thing about the Roth conversion strategy is that you can always change your mind well after the fact. Believe it or not, you have until Oct. 15, 2013, to “recharacterize” (unwind) a 2012 conversion. For example, say you convert a traditional IRA into a Roth account between now and year-end. Then the value of the converted account takes a nosedive. In this unhappy scenario, you would still have to pay extra 2012 income tax on value that later disappeared. Thankfully, that risk is mitigated by the fact that you have until Oct. 15,2013, to recharacterize the converted account back to traditional IRA status. After the recharacterization, it’s like the ill-advised 2012 conversion never happened. So you don’t owe any extra 2012 tax from the now-unwound conversion deal.

Relatively low current tax cost for converting, plus a chance to avoid higher tax rates scheduled for 2013 and beyond (think Taxmageddon) on income that will accumulate in your Roth account equals another perfect storm for the Roth conversion strategy. But you have to get it done this year to reap the tax-saving benefits. That said, please don’t get carried away. Consult a good tax pro before converting a traditional IRA with a significant balance. You want to be sure you understand exactly what you’re getting into.

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